A figure says a thousand words. And, looking at Figure 1, which shows the population-weighted average income per capita in emerging economies relative to the U.S., there could be no doubt in anybody’s mind that since the late 1990s something rather extraordinary happened—a phenomenon with no antecedents in the post-WWII period—that propelled emerging economies into an exponential process of convergence.

Needless to say, this phenomenon had enormous consequences for the welfare of millions of citizens in emerging economies. It lifted more than 500 million people out from poverty and extreme poverty, and gave rise to the so-called emerging middle class that grew at a rate of 150 million per year.

So, it seems that something rather extraordinary happened in emerging economies. Or did it? Let’s look again. When China and India are removed from the emerging markets sample, Figure 1 becomes Figure 2a.

In Figure 2a, one can still discern a period of convergence starting in the late 1990s. But convergence here was not nearly as strong—relative income is still far below its previous heights—and it occurred after a period of divergence that started in the mid-1970s after the first oil shock, in the early 1980s with the debt crisis, and in the late 1980s with post-Berlin Wall meltdown in Eastern European economies.

This pattern is actually characteristic of every emerging region including Latin America (see Figure 2b). Only Asia differs markedly from this pattern—with China and India displaying exponential convergence since the late 1990s, while the rest of emerging Asia experienced a sustained but much slower convergence since the mid-1960s.

From a Latin American perspective, the relevant question we need to ask is whether the recent bout of convergence that started in 2004 after a quarter of a century of relative income decline is a break with the past or just a short-lived phenomenon?

In order to address this question from a Latin American perspective, we study the arithmetic of convergence (i.e., whether mechanical projections are consistent with the convergence hypothesis) and the economics of convergence (i.e., whether income convergence was associated with a comparable convergence in the drivers of growth).

According to our definition of convergence,[1] since 1950, growth-convergence-development miracles represent a tiny fraction of emerging countries. Only five countries managed to achieve this: Japan, South Korea, Taiwan, Hong Kong and Singapore. In other words, convergence towards income per capita levels of rich countries is an extremely rare event.

But where does Latin America stand? Based on growth projections for the period 2014-2018, not a single Latin American country will converge to two-thirds of U.S. income per capita in two generations. Unfortunately, the arithmetic does not seem to be on the side of the region.

What about the economics? To answer this question, we analyze whether Latin America’s process of income convergence in the last decade was also associated with a similar convergence in the key drivers of growth: trade integration, physical and technological infrastructure, human capital, innovation, and the quality of public services. Figure 3 illustrates the results.

In contrast to relative income, during the last decade, LAC-7 [2] countries failed to converge towards advanced country levels in every growth driver. The overall index of growth drivers—the simple average of the five sub-indexes—remained unchanged in the last decade relative to the equivalent index for advanced economies. By and large, the latter holds true for every LAC-7 country with exceptions like Colombia (the only country that improved in every single growth driver in the last decade) and Chile (the country in the region where the levels of growth drivers are closer to those of advanced economies).

Latin America had a decade of uninterrupted high growth rates—with the sole exception of 2009 in the aftermath of the Lehman crisis—that put an end to a quarter of a century of relative decline in income per capita levels vis-à-vis advanced economies. However, high growth and income convergence were largely the result of an unusually favorable external environment, rather than the result of convergence to advanced-country levels in the key drivers of growth. Fundamentally, the last was a decade of “development-less growth” in Latin America.

With the extremely favorable external conditions already behind us, the region is expected to grow at mediocre rates of around 2 percent in per capita terms for the foreseeable future. With this level of growth, the dream of convergence and development is unlikely to be realized any time soon.

To avoid such a fate the region must make a renewed effort of economic transformation. Although the challenges ahead appear to be huge, there is plenty of room for optimism. First, Latin America has built a sound platform to launch a process of development. Democracy has by-and-large consolidated across the region, and an entire generation has now grown up to see an election as the only legitimate way to select national leaders. Moreover, it is for the most part a relatively stable region with no armed conflicts and few insurgency movements threatening the authority of the state. Second, a sizeable group of major countries in Latin America have a long track record of sound macroeconomic performance by now. Third, the region could be just steps away from major economic integration. Most Latin American countries in the Pacific Coast have bilateral free trade agreements with their North American neighbors (11 countries with the U.S. and seven countries with Canada). Were these countries to harmonize current bilateral trade agreements among themselves—in the way Pacific Alliance members have been doing—a huge economic space would be born: a Trans-American Partnership that would comprise 620 million consumers, and have a combined GDP of more than $22 trillion (larger than the EU’s, and more than double that of China). Were such a partnership on the Pacific side of the Americas to gain traction, it could eventually be extended to Atlantic partners, in particular Brazil and other Mercosur countries.

In the last quarter of a century democracy, sound macroeconomic management and an outward-looking development strategy made substantial strides in the region. If these conquests are consolidated and the same kind of progress is achieved in key development drivers in the next 25 years, many countries in the region could be on the road to convergence.

[1] We define convergence as a process whereby a country’s income per capita starts at or below one-third of U.S. income per capita at any point in time since 1950, and rises to or above two-thirds of U.S. income per capita.

[2] LAC-7 is the simple average of Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, which account for 93 percent of Latin America’s GDP.

A figure says a thousand words. And, looking at Figure 1, which shows the population-weighted average income per capita in emerging economies relative to the U.S., there could be no doubt in anybody’s mind that since the late 1990s something rather extraordinary happened—a phenomenon with no antecedents in the post-WWII period—that propelled emerging economies into an exponential process of convergence.

Needless to say, this phenomenon had enormous consequences for the welfare of millions of citizens in emerging economies. It lifted more than 500 million people out from poverty and extreme poverty, and gave rise to the so-called emerging middle class that grew at a rate of 150 million per year.

So, it seems that something rather extraordinary happened in emerging economies. Or did it? Let’s look again. When China and India are removed from the emerging markets sample, Figure 1 becomes Figure 2a.

In Figure 2a, one can still discern a period of convergence starting in the late 1990s. But convergence here was not nearly as strong—relative income is still far below its previous heights—and it occurred after a period of divergence that started in the mid-1970s after the first oil shock, in the early 1980s with the debt crisis, and in the late 1980s with post-Berlin Wall meltdown in Eastern European economies.

This pattern is actually characteristic of every emerging region including Latin America (see Figure 2b). Only Asia differs markedly from this pattern—with China and India displaying exponential convergence since the late 1990s, while the rest of emerging Asia experienced a sustained but much slower convergence since the mid-1960s.

From a Latin American perspective, the relevant question we need to ask is whether the recent bout of convergence that started in 2004 after a quarter of a century of relative income decline is a break with the past or just a short-lived phenomenon?

In order to address this question from a Latin American perspective, we study the arithmetic of convergence (i.e., whether mechanical projections are consistent with the convergence hypothesis) and the economics of convergence (i.e., whether income convergence was associated with a comparable convergence in the drivers of growth).

According to our definition of convergence,[1] since 1950, growth-convergence-development miracles represent a tiny fraction of emerging countries. Only five countries managed to achieve this: Japan, South Korea, Taiwan, Hong Kong and Singapore. In other words, convergence towards income per capita levels of rich countries is an extremely rare event.

But where does Latin America stand? Based on growth projections for the period 2014-2018, not a single Latin American country will converge to two-thirds of U.S. income per capita in two generations. Unfortunately, the arithmetic does not seem to be on the side of the region.

What about the economics? To answer this question, we analyze whether Latin America’s process of income convergence in the last decade was also associated with a similar convergence in the key drivers of growth: trade integration, physical and technological infrastructure, human capital, innovation, and the quality of public services. Figure 3 illustrates the results.

In contrast to relative income, during the last decade, LAC-7 [2] countries failed to converge towards advanced country levels in every growth driver. The overall index of growth drivers—the simple average of the five sub-indexes—remained unchanged in the last decade relative to the equivalent index for advanced economies. By and large, the latter holds true for every LAC-7 country with exceptions like Colombia (the only country that improved in every single growth driver in the last decade) and Chile (the country in the region where the levels of growth drivers are closer to those of advanced economies).

Latin America had a decade of uninterrupted high growth rates—with the sole exception of 2009 in the aftermath of the Lehman crisis—that put an end to a quarter of a century of relative decline in income per capita levels vis-à-vis advanced economies. However, high growth and income convergence were largely the result of an unusually favorable external environment, rather than the result of convergence to advanced-country levels in the key drivers of growth. Fundamentally, the last was a decade of “development-less growth” in Latin America.

With the extremely favorable external conditions already behind us, the region is expected to grow at mediocre rates of around 2 percent in per capita terms for the foreseeable future. With this level of growth, the dream of convergence and development is unlikely to be realized any time soon.

To avoid such a fate the region must make a renewed effort of economic transformation. Although the challenges ahead appear to be huge, there is plenty of room for optimism. First, Latin America has built a sound platform to launch a process of development. Democracy has by-and-large consolidated across the region, and an entire generation has now grown up to see an election as the only legitimate way to select national leaders. Moreover, it is for the most part a relatively stable region with no armed conflicts and few insurgency movements threatening the authority of the state. Second, a sizeable group of major countries in Latin America have a long track record of sound macroeconomic performance by now. Third, the region could be just steps away from major economic integration. Most Latin American countries in the Pacific Coast have bilateral free trade agreements with their North American neighbors (11 countries with the U.S. and seven countries with Canada). Were these countries to harmonize current bilateral trade agreements among themselves—in the way Pacific Alliance members have been doing—a huge economic space would be born: a Trans-American Partnership that would comprise 620 million consumers, and have a combined GDP of more than $22 trillion (larger than the EU’s, and more than double that of China). Were such a partnership on the Pacific side of the Americas to gain traction, it could eventually be extended to Atlantic partners, in particular Brazil and other Mercosur countries.

In the last quarter of a century democracy, sound macroeconomic management and an outward-looking development strategy made substantial strides in the region. If these conquests are consolidated and the same kind of progress is achieved in key development drivers in the next 25 years, many countries in the region could be on the road to convergence.

[1] We define convergence as a process whereby a country’s income per capita starts at or below one-third of U.S. income per capita at any point in time since 1950, and rises to or above two-thirds of U.S. income per capita.

[2] LAC-7 is the simple average of Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, which account for 93 percent of Latin America’s GDP.

“Latin America actually lacks an identity because it has them all,” says Ernesto Talvi—a Brookings nonresident senior fellow—as he reflects on how Peruvian poet Mario Vargas Llosa described Latin America. In this podcast, Talvi, who directs the Brookings Global-CERES Economic and Social Policy in Latin America Initiative, explains why there are actually three Latin Americas based on macroeconomic factors; why nations such as Chile, Peru, Mexico and Colombia have very strong fundamentals (and why Argentina and Venezuela are troubling); why economic growth has slowed in the region since 2011; and why inequalities throughout the region are inconsistent with a stable social order. Also, listen to find out why Talvi chose the University of Chicago and its frigid winters for graduate study in economics, a world away from his temperate native country, Uruguay.

(26:13) In one of our regular special segments, Governance Studies Fellow John Hudak describes the blog series on the most important issues and Senate races in the upcoming midterm elections. Visit FixGov blog to learn more.

Authors

“Latin America actually lacks an identity because it has them all,” says Ernesto Talvi—a Brookings nonresident senior fellow—as he reflects on how Peruvian poet Mario Vargas Llosa described Latin America. In this podcast, Talvi, who directs the Brookings Global-CERES Economic and Social Policy in Latin America Initiative, explains why there are actually three Latin Americas based on macroeconomic factors; why nations such as Chile, Peru, Mexico and Colombia have very strong fundamentals (and why Argentina and Venezuela are troubling); why economic growth has slowed in the region since 2011; and why inequalities throughout the region are inconsistent with a stable social order. Also, listen to find out why Talvi chose the University of Chicago and its frigid winters for graduate study in economics, a world away from his temperate native country, Uruguay.

(26:13) In one of our regular special segments, Governance Studies Fellow John Hudak describes the blog series on the most important issues and Senate races in the upcoming midterm elections. Visit FixGov blog to learn more.

Editor’s Note: On October 25–28, 2014, Ernesto Talvi participated in the Latin America Shadow Financial Regulatory Committee (CLAAF), held in Lima, Peru. The committee is composed of a group of prestigious independent Latin American economists, former policymakers, and academics with strong expertise in the field of macroeconomics, banking and finance and whose goal is to identify and analyze challenges and risks for the region. The following document—Policy Statement Number 32—was released at a press conference held at Universidad del Pacífico in Lima, immediately following the meetings. It discusses the risks associated with a major slowdown in emerging economies and with the possibility that emerging market asset liquidity might fall significantly when the FED increases interest rates. A series of preventive policy actions for Latin American countries and the international community are recommended by the Committee.

I. Change in Growth Perspectives of the Global Economy

Towards the end of the 2008 economic crisis, the consensus was that developed economies
would recover just as quickly as they did in past recessions. It was also expected that emerging
market economies would continue acting as the world growth locomotive for a relatively long
time. Until mid-2011, this perspective appeared to be in the process of materializing. By now,
however, this scenario differs significantly from reality. For example, projections on economic
growth published by the IMF at the October 2009 World Economic Outlook (WEO) forecasted a
global economic growth rate of 4.5% for 2014, while the latest version of the estimate reduced
the forecast to 3.3%. While the adjustment is minimal in the case of the United States, forecast
revisions are important in some other regions. In Europe the projection was adjusted by -1.3%; in
Japan by -0.9%; and in the emerging world by -2.2%.

Consensus among international economic analysts has, therefore, become increasingly
pessimistic and projection adjustments reflect the fact that the observed recovery has actually
been weaker than expected. In the case of developed economies, the slow recovery has even led
some experts to suggest the possibility of getting into a secular stagnation process, increasingly
emphasizing the need to implement structural reforms in order to foster innovation and
productivity. Stagnation in Europe in particular has reached the entire continent.

Forecast revisions have been particularly strong in the case of Latin America. The WEO growth
forecast has been revised downwards from 4% to 1.3% in the period between 2009 and 2014.
The regions’ largest economies have suffered the greatest revisions for 2014. Between 2009 and
now, the revision for Argentina stands at -4.7%; in Brazil, Chile and Venezuela at -3.4%, in
Mexico at -2.5% and in Peru at -1.9%.
CLAAF Declaration

In Latin America, most of these revisions are mainly explained by a reversion in growth rates
towards potential rates similar to historical averages following a strong expansionary period.
This would interrupt the catch-up process of the region’s GDP –relative to the US GDP- that
started in 2003.

Indeed, as discussed in CLAAF’s Statement N° 26, the region benefitted from the aggressive
response to the 2008 crisis by advanced economies’ central banks (particularly the FED). The
strong reductions in interest rates and the massive purchases of financial assets significantly
changed the international capital market dynamics, and facilitated an increased demand for Latin
American’s assets. Between 2010 and 2013, the region increased its external funding in order to
sustain increasing public and private expenditures; this translated into larger current account
deficits.

At the same time, the region benefited from the strong anti-cyclical Chinese policy in the
aftermath of the 2008 crisis. In China, economic policy was even more expansive than that in
developed countries. This policy included substantial bank and non-bank credit expansions, and
a boost for commodity demand.

Part of Latin America’s slowdown is clearly cyclical. After the boom in commodity prices, there
was a strong increase in investments related to these industries, which is now coming to an end.
This has been particularly relevant in Chile and Peru. Also, in some economies, domestic policy
difficulties and uncertainty towards reform implementation have curbed demand expansion.

The monetary stimuli in the United States and other parts of the developed world, as well as
China’s credit expansion, mitigated the effects the 2008 crisis had on expenditure and growth
rates in the region. However, as the US FED has initiated announcement of measures to
normalize its monetary policy position (suggesting a plausible increase in interest rates by mid-
2015) the region’s financial markets have been adversely affected. For example, the region’s
currencies have depreciated and country-risk premiums have risen.

II. Additional Risk Factors in the Global Scenario

Compared to the scenario described above, the Committee has identified two additional risk
factors that have not been appropriately internalized by the current consensus. First, we are
witnessing a global financial phenomenon without precedent in the post-war era. The mortgage
crisis originated in developed countries and had strong repercussions in developing countries.
These repercussions had an unexpected turn. Initially, the markets feared a severe recession in
developing countries given the experience during the 1998 Russian crisis, when a relatively
smaller shock related to the partial default of the Russian debt had a very strong generalized
impact in emerging economies. In contrast, the mortgage crisis of 2008 was associated with a
fast unexpected dynamic recovery until mid-2011, after having caused a drastic export contraction in developing countries. This is one of the most novel aspects in the crisis’ post-
Lehman phase.

The Lehman’s crisis caused a massive and significant destruction of low-risk, highly- liquid
assets, the so-called Safe Assets. These assets constitute an important source of credit collateral.
Some estimates place the destruction of low-risk, highly- liquid assets at 25 percent of global
GDP. This created an excess demand for safe assets, which in turn generated incentives to
demand other assets with similar liquidity characteristics, although not at the same low-risk
level.

Because emerging countries’ assets suffered relatively less during the global financial crisis, they
became a good alternative to the traditional low-risk, highly-liquid assets; thus improving their
liquidity. In Latin America, during the pre-crisis period, a number of countries experienced
improvements in their credit rating and some reached investment grade. This supported the
increased demand for these countries’ assets by institutional investors, such as pension funds and
insurance companies.

A short-term interest rate close to zero in developed countries and the fact that the Lehman crisis
led to greater banking regulations in developed countries (capital and liquidity requirements)
fostered liquidity creation in emerging countries. This gave way to a strong expansion in the
activities of institutions, such as investment and hedge funds, much less regulated and with lesser
limitations for financial intermediation and for maintaining risk assets in their portfolios. This
process, in turn, supported greater liquidity for emerging markets’ bonds.

A main problem faced by emerging markets is that asset liquidity might fall significantly when
the FED increase interest rates, a move the market has started to anticipate. The FED has already
started tightening its monetary policy through the finalization of the Quantitative Easing (QE)
program. However, the end of QE is much less dangerous for emerging markets’ assets liquidity
than increasing the policy interest rate in developed countries, given that high-liquidity assets
(such as the US Treasury bonds) directly compete with the developing countries’ liquid assets, especially those that expanded in response to the financial crisis. This factor raises deep concerns
about a potential dry-up in the flow of capital towards emerging markets following an increase in
international interest rates (that is, a Sudden Stop). These fears include risks of an important
contraction in the level of activity and employment.

An additional problem is the FED’s lack of clarity regarding its future decisions, due to the high
complexity of the situation. The normalization of financial conditions in the US should be
accompanied by an increase in interest rates to prevent inflation. However, interest rate increases
can lead to important impacts in that country and in the global economy that are difficult to
anticipate. This creates a dilemma for the FED; one that can generate uncertainty on the nature
and timing of its decisions.

A second risk factor is that there are strong reasons indicating a deeper slowdown in China’s
economic growth than the forecasts by the current international consensus. On the one hand,
investment quality has been uneven, since it gave way to excess capacity in the real estate
industry and to an increase in spending by local governments in ambitious, but not very efficient
infrastructure projects. In turn, the decreasing quality of projects, together with a significant
indebtedness by companies and local governments, might lead to lower investment rates and
growth prospects. In fact, investment in the real estate market has already started to fall and
housing prices in several cities have started to go down.

On the other hand, the rapid increase of China’s investment has been linked to an equally rapid
increase of domestic credit. Total social funding reached almost 120 percent of GDP in 2008 and
more than 200 percent of GDP in 2014.[1] Although a great deal of credit expansion has taken
place through the regulated banking system, credit has been increasingly channeled through trust
funds and other non-regulated instruments, usually known as “shadow banking”. Assets in this
category are currently estimated at 30 percent of assets in the traditional banking system. The
combination of a credit boom with low-productivity investments has increased the fragility of the
financial system in China.

III. Regional Risk Factors

A third risk factor which is particularly relevant for the region is the possibility that commodity
prices might fall faster than what the current consensus considers. In fact, we have recently seen
a significant reduction in the price of agricultural products, oil and metals from their highest
peaks.

These additional risks that the Committee has identified find Latin America in more fragile
initial conditions than in 2008. Firstly, excessive public and/or private expenditure and
insufficient savings ratios led to a deterioration of current account balances even before the
decline in commodities prices. Secondly, public sector deficits increased significantly in several
countries, including those where counter-cyclical fiscal policies adopted in 2009 were not
reverted during the subsequent recovery. Thirdly, domestic costs of production increased faster
than productivity, reducing competitiveness in non-commodity tradable industries. Fourthly,
indebtedness levels of firms and families are relatively high in several countries. Fifthly, efforts
for increasing productivity in the region have clearly been insufficient.

Under these conditions, the likelihood of reductions in credit ratings of some countries has
increased. This possibility may become generalized if, as a consequence of an increase in the US
interest rates, there were a risk revision of the asset class formed by emerging markets bonds.

Likewise, the combination of the above mentioned factors might generate sudden currency
depreciations which, in some countries that are still highly financially-dollarized, might generate
adverse effects on the balance sheets of the public sector and of non-tradable private sectors. In
other countries, where there still exists a significant pass-through, these factors might generate
inflationary pressures.

IV. Policy Implications

The risks from the global scenario described above have a clearly systemic dimension. A sudden
increase in international interest rates, together with a fall in the price of a wide range of assets,
in the context of an economic slowdown, can generate a strong loss of investors’ confidence on
emerging economies. The Committee believes that if this scenario materializes, the current
financial architecture, made up by local central banks and multilateral institutions will be
inadequate to respond to the challenges entailed by such scenario. Therefore, restoring
confidence will very likely require new liquidity support by the FED, this time towards emerging
economies. However, it seems unlikely that such action will be supported by the US Congress to
the extent that US recovery continues in its consolidation process, and that injecting liquidity is
not clearly in the interest of the United States.

In this context, the Committee believes that it is desirable to strengthen the international financial
architecture to improve its capability to respond to a sudden deterioration in global financial
markets. The Committee particularly favors the creation of an Emerging Markets Fund (EMF)
with the capacity to intervene in sovereign debt markets for the purpose of reducing volatility.
Such a fund may intervene in debt markets in case of systemic financial turmoil and under
predetermined rules; such actions could include transactions based in a bond basket (for example
the EMBI basket). The fund may also establish swap lines with central banks of the same type
that took place during the global financial crisis.

A potential problem with this kind of initiative is that it is subjected to usual criticisms regarding
moral hazard. However, the Committee believes that this is not a major problem because the
EMF is focused in establishing a bond basket price index that includes bonds from many
countries and not for individual countries. Even if the moral hazard argument has some merit,
and even if the EMF can experience losses in its interventions, the 2008-2009 crisis experience
demonstrated that counting with powerful instruments, witch lender of last resort characteristics,
in systemic situations of loss confidence derives in benefits that exceed the costs.

In previous CLAAF statements (see Statement No. 27), the Committee has already clearly
expressed the need to complement the role of current multilateral organizations, particularly the
IMF through the creation of regional institutions. In this regard, the Committee favors the
creation of a Latin American Liquidity Fund mainly aiming at: 1) providing liquidity to the
public sector, and 2) providing credit that can mitigate the possible volatility in trade credit lines.
The Committee estimated that such institution should need a capitalization of US$ 50 billion and a lending capacity of US$ 100 billion, equivalent to the net liquidity needs by the region during
the 2008-2009 crisis.

Facing the current scenario, the Committee recommends the countries in the region to run new
stress tests so as to update possible financial needs for the public and private sectors that might
arise if the FED increases interest rates suddenly in the context of the current economic
slowdown and fall of commodity international prices.

In the preceding sections we have identified the growth of “shadow banking” –a response to
greater regulatory constraints on the traditional banking system- as an important source of risk.
To contain regulatory arbitrage, the Committee recommends that financial activities with similar
characteristics should be treated coherently in the regions’ regulatory frameworks; without
distinguishing whether such activities are carried out by a bank or another entity if systemic risks
-which require potential action from a lender of last resort, such as a central bank- derive from
such activities. This implies a change in the traditional regulatory approach form “regulation by
type of institution” to “regulation by function”. In addition, it is advisable to exclude public
sector liabilities from the definition of “highest-liquidity assets” recommended by Basel III in
countries whose sovereign liabilities are subject to high volatility in the contexts of financial
turmoil. This would prevent interconnectedness between sovereign risk and financial risk.

The above mentioned change of approach concerning regulatory frameworks suggests the
convenience of consolidating regulatory and banking supervision with responsibilities for capital
markets and insurance oversight. Some countries in the region, such as Colombia and Mexico,
have already moved in this direction. However, in the US and the EU there is still separation
between banking and capital market regulators.

The prospects for increasing volatility in capital markets causing the region to face sharp
downturns in capital inflows also implies challenges to domestic economic policies. Turbulences
in capital markets may generate a contraction in banking credit that may exacerbate the adverse
effects on economic growth. It was demonstrated -during the 2008 and 2009 crisis- that in such
case public banks may play a beneficial counter-cyclical role that could mitigates the contraction
of private banks’ credit. In countries where there are public banks, the Committee believes the
counter-cyclical role of credit provided by those institutions should be strengthened. To do so,
public banks should explicitly adopt said policy objective and develop specific strategies to
appropriately exercise such role.

In terms of exchange policy, the Committee reminds the region about the importance of keeping
appropriate exchange rate flexibility and avoiding “fear to float” behaviors. The countries that
are most able to reduce currency mismatches in balance sheets and dollarization will be in better
position to face the challenges of a greater financial volatility and lower economic growth.

[1] Social funding is defined by the Popular Bank of China as an economic barometer that adds up total funding by non-public Chinese entities, including non-financial individuals and companies.

Editor’s Note: On October 25–28, 2014, Ernesto Talvi participated in the Latin America Shadow Financial Regulatory Committee (CLAAF), held in Lima, Peru. The committee is composed of a group of prestigious independent Latin American economists, former policymakers, and academics with strong expertise in the field of macroeconomics, banking and finance and whose goal is to identify and analyze challenges and risks for the region. The following document—Policy Statement Number 32—was released at a press conference held at Universidad del Pacífico in Lima, immediately following the meetings. It discusses the risks associated with a major slowdown in emerging economies and with the possibility that emerging market asset liquidity might fall significantly when the FED increases interest rates. A series of preventive policy actions for Latin American countries and the international community are recommended by the Committee.

I. Change in Growth Perspectives of the Global Economy

Towards the end of the 2008 economic crisis, the consensus was that developed economies
would recover just as quickly as they did in past recessions. It was also expected that emerging
market economies would continue acting as the world growth locomotive for a relatively long
time. Until mid-2011, this perspective appeared to be in the process of materializing. By now,
however, this scenario differs significantly from reality. For example, projections on economic
growth published by the IMF at the October 2009 World Economic Outlook (WEO) forecasted a
global economic growth rate of 4.5% for 2014, while the latest version of the estimate reduced
the forecast to 3.3%. While the adjustment is minimal in the case of the United States, forecast
revisions are important in some other regions. In Europe the projection was adjusted by -1.3%; in
Japan by -0.9%; and in the emerging world by -2.2%.

Consensus among international economic analysts has, therefore, become increasingly
pessimistic and projection adjustments reflect the fact that the observed recovery has actually
been weaker than expected. In the case of developed economies, the slow recovery has even led
some experts to suggest the possibility of getting into a secular stagnation process, increasingly
emphasizing the need to implement structural reforms in order to foster innovation and
productivity. Stagnation in Europe in particular has reached the entire continent.

Forecast revisions have been particularly strong in the case of Latin America. The WEO growth
forecast has been revised downwards from 4% to 1.3% in the period between 2009 and 2014.
The regions’ largest economies have suffered the greatest revisions for 2014. Between 2009 and
now, the revision for Argentina stands at -4.7%; in Brazil, Chile and Venezuela at -3.4%, in
Mexico at -2.5% and in Peru at -1.9%.
CLAAF Declaration

In Latin America, most of these revisions are mainly explained by a reversion in growth rates
towards potential rates similar to historical averages following a strong expansionary period.
This would interrupt the catch-up process of the region’s GDP –relative to the US GDP- that
started in 2003.

Indeed, as discussed in CLAAF’s Statement N° 26, the region benefitted from the aggressive
response to the 2008 crisis by advanced economies’ central banks (particularly the FED). The
strong reductions in interest rates and the massive purchases of financial assets significantly
changed the international capital market dynamics, and facilitated an increased demand for Latin
American’s assets. Between 2010 and 2013, the region increased its external funding in order to
sustain increasing public and private expenditures; this translated into larger current account
deficits.

At the same time, the region benefited from the strong anti-cyclical Chinese policy in the
aftermath of the 2008 crisis. In China, economic policy was even more expansive than that in
developed countries. This policy included substantial bank and non-bank credit expansions, and
a boost for commodity demand.

Part of Latin America’s slowdown is clearly cyclical. After the boom in commodity prices, there
was a strong increase in investments related to these industries, which is now coming to an end.
This has been particularly relevant in Chile and Peru. Also, in some economies, domestic policy
difficulties and uncertainty towards reform implementation have curbed demand expansion.

The monetary stimuli in the United States and other parts of the developed world, as well as
China’s credit expansion, mitigated the effects the 2008 crisis had on expenditure and growth
rates in the region. However, as the US FED has initiated announcement of measures to
normalize its monetary policy position (suggesting a plausible increase in interest rates by mid-
2015) the region’s financial markets have been adversely affected. For example, the region’s
currencies have depreciated and country-risk premiums have risen.

II. Additional Risk Factors in the Global Scenario

Compared to the scenario described above, the Committee has identified two additional risk
factors that have not been appropriately internalized by the current consensus. First, we are
witnessing a global financial phenomenon without precedent in the post-war era. The mortgage
crisis originated in developed countries and had strong repercussions in developing countries.
These repercussions had an unexpected turn. Initially, the markets feared a severe recession in
developing countries given the experience during the 1998 Russian crisis, when a relatively
smaller shock related to the partial default of the Russian debt had a very strong generalized
impact in emerging economies. In contrast, the mortgage crisis of 2008 was associated with a
fast unexpected dynamic recovery until mid-2011, after having caused a drastic export contraction in developing countries. This is one of the most novel aspects in the crisis’ post-
Lehman phase.

The Lehman’s crisis caused a massive and significant destruction of low-risk, highly- liquid
assets, the so-called Safe Assets. These assets constitute an important source of credit collateral.
Some estimates place the destruction of low-risk, highly- liquid assets at 25 percent of global
GDP. This created an excess demand for safe assets, which in turn generated incentives to
demand other assets with similar liquidity characteristics, although not at the same low-risk
level.

Because emerging countries’ assets suffered relatively less during the global financial crisis, they
became a good alternative to the traditional low-risk, highly-liquid assets; thus improving their
liquidity. In Latin America, during the pre-crisis period, a number of countries experienced
improvements in their credit rating and some reached investment grade. This supported the
increased demand for these countries’ assets by institutional investors, such as pension funds and
insurance companies.

A short-term interest rate close to zero in developed countries and the fact that the Lehman crisis
led to greater banking regulations in developed countries (capital and liquidity requirements)
fostered liquidity creation in emerging countries. This gave way to a strong expansion in the
activities of institutions, such as investment and hedge funds, much less regulated and with lesser
limitations for financial intermediation and for maintaining risk assets in their portfolios. This
process, in turn, supported greater liquidity for emerging markets’ bonds.

A main problem faced by emerging markets is that asset liquidity might fall significantly when
the FED increase interest rates, a move the market has started to anticipate. The FED has already
started tightening its monetary policy through the finalization of the Quantitative Easing (QE)
program. However, the end of QE is much less dangerous for emerging markets’ assets liquidity
than increasing the policy interest rate in developed countries, given that high-liquidity assets
(such as the US Treasury bonds) directly compete with the developing countries’ liquid assets, especially those that expanded in response to the financial crisis. This factor raises deep concerns
about a potential dry-up in the flow of capital towards emerging markets following an increase in
international interest rates (that is, a Sudden Stop). These fears include risks of an important
contraction in the level of activity and employment.

An additional problem is the FED’s lack of clarity regarding its future decisions, due to the high
complexity of the situation. The normalization of financial conditions in the US should be
accompanied by an increase in interest rates to prevent inflation. However, interest rate increases
can lead to important impacts in that country and in the global economy that are difficult to
anticipate. This creates a dilemma for the FED; one that can generate uncertainty on the nature
and timing of its decisions.

A second risk factor is that there are strong reasons indicating a deeper slowdown in China’s
economic growth than the forecasts by the current international consensus. On the one hand,
investment quality has been uneven, since it gave way to excess capacity in the real estate
industry and to an increase in spending by local governments in ambitious, but not very efficient
infrastructure projects. In turn, the decreasing quality of projects, together with a significant
indebtedness by companies and local governments, might lead to lower investment rates and
growth prospects. In fact, investment in the real estate market has already started to fall and
housing prices in several cities have started to go down.

On the other hand, the rapid increase of China’s investment has been linked to an equally rapid
increase of domestic credit. Total social funding reached almost 120 percent of GDP in 2008 and
more than 200 percent of GDP in 2014.[1] Although a great deal of credit expansion has taken
place through the regulated banking system, credit has been increasingly channeled through trust
funds and other non-regulated instruments, usually known as “shadow banking”. Assets in this
category are currently estimated at 30 percent of assets in the traditional banking system. The
combination of a credit boom with low-productivity investments has increased the fragility of the
financial system in China.

III. Regional Risk Factors

A third risk factor which is particularly relevant for the region is the possibility that commodity
prices might fall faster than what the current consensus considers. In fact, we have recently seen
a significant reduction in the price of agricultural products, oil and metals from their highest
peaks.

These additional risks that the Committee has identified find Latin America in more fragile
initial conditions than in 2008. Firstly, excessive public and/or private expenditure and
insufficient savings ratios led to a deterioration of current account balances even before the
decline in commodities prices. Secondly, public sector deficits increased significantly in several
countries, including those where counter-cyclical fiscal policies adopted in 2009 were not
reverted during the subsequent recovery. Thirdly, domestic costs of production increased faster
than productivity, reducing competitiveness in non-commodity tradable industries. Fourthly,
indebtedness levels of firms and families are relatively high in several countries. Fifthly, efforts
for increasing productivity in the region have clearly been insufficient.

Under these conditions, the likelihood of reductions in credit ratings of some countries has
increased. This possibility may become generalized if, as a consequence of an increase in the US
interest rates, there were a risk revision of the asset class formed by emerging markets bonds.

Likewise, the combination of the above mentioned factors might generate sudden currency
depreciations which, in some countries that are still highly financially-dollarized, might generate
adverse effects on the balance sheets of the public sector and of non-tradable private sectors. In
other countries, where there still exists a significant pass-through, these factors might generate
inflationary pressures.

IV. Policy Implications

The risks from the global scenario described above have a clearly systemic dimension. A sudden
increase in international interest rates, together with a fall in the price of a wide range of assets,
in the context of an economic slowdown, can generate a strong loss of investors’ confidence on
emerging economies. The Committee believes that if this scenario materializes, the current
financial architecture, made up by local central banks and multilateral institutions will be
inadequate to respond to the challenges entailed by such scenario. Therefore, restoring
confidence will very likely require new liquidity support by the FED, this time towards emerging
economies. However, it seems unlikely that such action will be supported by the US Congress to
the extent that US recovery continues in its consolidation process, and that injecting liquidity is
not clearly in the interest of the United States.

In this context, the Committee believes that it is desirable to strengthen the international financial
architecture to improve its capability to respond to a sudden deterioration in global financial
markets. The Committee particularly favors the creation of an Emerging Markets Fund (EMF)
with the capacity to intervene in sovereign debt markets for the purpose of reducing volatility.
Such a fund may intervene in debt markets in case of systemic financial turmoil and under
predetermined rules; such actions could include transactions based in a bond basket (for example
the EMBI basket). The fund may also establish swap lines with central banks of the same type
that took place during the global financial crisis.

A potential problem with this kind of initiative is that it is subjected to usual criticisms regarding
moral hazard. However, the Committee believes that this is not a major problem because the
EMF is focused in establishing a bond basket price index that includes bonds from many
countries and not for individual countries. Even if the moral hazard argument has some merit,
and even if the EMF can experience losses in its interventions, the 2008-2009 crisis experience
demonstrated that counting with powerful instruments, witch lender of last resort characteristics,
in systemic situations of loss confidence derives in benefits that exceed the costs.

In previous CLAAF statements (see Statement No. 27), the Committee has already clearly
expressed the need to complement the role of current multilateral organizations, particularly the
IMF through the creation of regional institutions. In this regard, the Committee favors the
creation of a Latin American Liquidity Fund mainly aiming at: 1) providing liquidity to the
public sector, and 2) providing credit that can mitigate the possible volatility in trade credit lines.
The Committee estimated that such institution should need a capitalization of US$ 50 billion and a lending capacity of US$ 100 billion, equivalent to the net liquidity needs by the region during
the 2008-2009 crisis.

Facing the current scenario, the Committee recommends the countries in the region to run new
stress tests so as to update possible financial needs for the public and private sectors that might
arise if the FED increases interest rates suddenly in the context of the current economic
slowdown and fall of commodity international prices.

In the preceding sections we have identified the growth of “shadow banking” –a response to
greater regulatory constraints on the traditional banking system- as an important source of risk.
To contain regulatory arbitrage, the Committee recommends that financial activities with similar
characteristics should be treated coherently in the regions’ regulatory frameworks; without
distinguishing whether such activities are carried out by a bank or another entity if systemic risks
-which require potential action from a lender of last resort, such as a central bank- derive from
such activities. This implies a change in the traditional regulatory approach form “regulation by
type of institution” to “regulation by function”. In addition, it is advisable to exclude public
sector liabilities from the definition of “highest-liquidity assets” recommended by Basel III in
countries whose sovereign liabilities are subject to high volatility in the contexts of financial
turmoil. This would prevent interconnectedness between sovereign risk and financial risk.

The above mentioned change of approach concerning regulatory frameworks suggests the
convenience of consolidating regulatory and banking supervision with responsibilities for capital
markets and insurance oversight. Some countries in the region, such as Colombia and Mexico,
have already moved in this direction. However, in the US and the EU there is still separation
between banking and capital market regulators.

The prospects for increasing volatility in capital markets causing the region to face sharp
downturns in capital inflows also implies challenges to domestic economic policies. Turbulences
in capital markets may generate a contraction in banking credit that may exacerbate the adverse
effects on economic growth. It was demonstrated -during the 2008 and 2009 crisis- that in such
case public banks may play a beneficial counter-cyclical role that could mitigates the contraction
of private banks’ credit. In countries where there are public banks, the Committee believes the
counter-cyclical role of credit provided by those institutions should be strengthened. To do so,
public banks should explicitly adopt said policy objective and develop specific strategies to
appropriately exercise such role.

In terms of exchange policy, the Committee reminds the region about the importance of keeping
appropriate exchange rate flexibility and avoiding “fear to float” behaviors. The countries that
are most able to reduce currency mismatches in balance sheets and dollarization will be in better
position to face the challenges of a greater financial volatility and lower economic growth.

[1] Social funding is defined by the Popular Bank of China as an economic barometer that adds up total funding by non-public Chinese entities, including non-financial individuals and companies.

Authors

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http://www.brookings.edu/events/2014/10/14-latin-america-political-outlook?rssid=talvie{2CCF11DB-4F5D-4FFE-96E2-03A196E7E039}http://webfeeds.brookings.edu/~/76609082/0/brookingsrss/experts/talvie~Latin-Americas-Political-Outlook-in-the-Wake-of-the-Current-Election-CycleLatin America's Political Outlook in the Wake of the Current Election Cycle

Event Information

By the end of 2014, 12 Latin American countries will have had presidential elections over the past two years. After a decade of strong growth, the region faces a troubling combination of decelerating economies and rising social expectations. How will governments respond and what are the implications for the direction of social, economic, trade and foreign policy in Latin America?

On October 14, the Brookings Foreign Policy Latin America Initiative and the Brookings Global-CERES Economic and Social Policy in Latin America Initiative hosted a discussion on the political outlook for the region. Panelists included: Kevin Casas-Zamora, secretary for political affairs at the Organization of American States; Julia Sweig, Nelson and David Rockefeller senior fellow and director for Latin American studies at the Council on Foreign Relations; Harold Trinkunas, senior fellow and director of the Foreign Policy Latin America Initiative at Brookings; and Arturo Valenzuela, professor of government at Georgetown University and former Assistant Secretary of State for Western Hemisphere Affairs. Ernesto Talvi, director of the Brookings Global-CERES Economic and Social Policy in Latin America Initiative, moderated the discussion.

Event Information

By the end of 2014, 12 Latin American countries will have had presidential elections over the past two years. After a decade of strong growth, the region faces a troubling combination of decelerating economies and rising social expectations. How will governments respond and what are the implications for the direction of social, economic, trade and foreign policy in Latin America?

On October 14, the Brookings Foreign Policy Latin America Initiative and the Brookings Global-CERES Economic and Social Policy in Latin America Initiative hosted a discussion on the political outlook for the region. Panelists included: Kevin Casas-Zamora, secretary for political affairs at the Organization of American States; Julia Sweig, Nelson and David Rockefeller senior fellow and director for Latin American studies at the Council on Foreign Relations; Harold Trinkunas, senior fellow and director of the Foreign Policy Latin America Initiative at Brookings; and Arturo Valenzuela, professor of government at Georgetown University and former Assistant Secretary of State for Western Hemisphere Affairs. Ernesto Talvi, director of the Brookings Global-CERES Economic and Social Policy in Latin America Initiative, moderated the discussion.

After a decade of high growth and high expectations about the region’s future, the new and less complacent global context implies a return to lackluster growth rates of 3.3 percent over the next five years, from 2014 to 2018. Such a reduction in the cruising speed of the region comes as a result of the change in outlook for growth in advanced economies (mired in what has been called “secular stagnation”); the imminent end to China’s investment-led, credit-propelled growth model and further slowdown in its economy; softening commodity prices; and a gradual increase in the cost of international financing for emerging markets.

What are the macroeconomic challenges that lie ahead for the region? To answer this question we have constructed a series of indicators that are comparable across countries. Every indicator is normalized so that whenever the value is below 1 it denotes a positive outlook and when the value is above 1 it denotes a negative outlook in each macroeconomic dimension.

What emerges is a not a narrative of one Latin America, but of three: one with sound macroeconomic fundamentals (Chile, Colombia, Mexico and Peru), one with weak fundamentals (Argentina and Venezuela), and one with mixed fundamentals (Brazil). Each cluster faces a different outlook and different policy challenges.

Source: Own calculations based on the IMF Financial Soundness Indicators and national statistics for Venezuela.

After a string of banking crises, debt restructurings and financial distress, the health of the financial system in the region has improved significantly. Clearly, the tightening of the regulation and supervision of the region’s banking systems during the last decade appears to have paid off.

In order to assess the banking outlook, we developed a Banking Vulnerability Ratio defined as the ratio of projected nonperforming loans under more adverse economic conditions—higher interest rates, lower growth and depreciating currencies—to maximum nonperforming loans (defined as the level of non-performing loans that would exhaust existing loan-loss provisions and bank capital). Surprisingly, the Banking Vulnerability Ratio is below 1 for each and every country in the region, meaning that if we rule out extreme events, banks in the region are in a strong position to endure a deterioration in economic conditions. From a macroeconomic perspective, this time around the weak link does not appear to be the banking system.

Source: Own calculations based on national statistics, IMF, IADB, CAF and FLAR.

Since the beginning of the cooling-off period in mid-2011, there has been a sharp contrast in the behavior of international reserves between countries with full access and those with limited access to international financial markets. While they have continued to increase in the former (Brazil, Chile, Colombia, Mexico and Peru), they declined significantly in the latter (Argentina and Venezuela).

To assess the international liquidity position we developed the International Liquidity Ratio. The International Liquidity Ratio is defined as the ratio of short-term debt obligations of the public sector—both domestic and external and including the stock of central bank sterilization in­struments—and short-term external debt obligations of the corporate non-financial private sector due in the next 12 months to international reserves, plus the already agreed ex-ante contingent credit lines and potential credit lines that could be negotiated with multilat­eral or regional financial institutions.

We find that the countries in the first cluster—Chile, Colombia, Mexico and Peru—have a strong liquidity position which provides them with an effective cushion to weather episodes of financial turbulence in international capital markets, while Argentina and Venezuela have a very weak international liquidity position. Brazil is in an intermediate, borderline position.

Source: National statistics and private sector estimations for Argentina. Forecasts are obtained from FocusEconomics and Econviews for Argentina.

In order to assess the inflation outlook, we consider a country to have a positive (negative) outlook for inflation if it is expected to remain or fall below (rise above) 4 percent in the next three years. With this definition, we developed an Inflation Vulnerability Ratio, defined as the ratio of projected inflation at the end of 2016 to a 4 percent inflation threshold.

Once again, a heterogeneous picture arises in which some countries have a very negative inflation outlook (Argentina and Venezuela) and face the need to make substantial policy adjustments, while some others have an extraordinarily strong and sustained track record of very low and relatively stable inflation rates (Chile, Colombia, Mexico and Peru). Brazil misses the mark by a relatively small margin.

Source: Own calculations based on national statistics and IMF World Economic Outlook.

To evaluate the strength of the fis­cal position we de­veloped a Fiscal Vulnerability Ratio. The Fiscal Vulnerability Ratio is defined as the ratio of projected debt to GDP over 15 years (assuming identical inflation tax revenues for every country) to a 50 percent debt to GDP thresh­old.

A very diverse picture emerges between countries with very vulnerable fiscal positions (Argentina and Venezuela) facing the need to make substantial policy adjustments to stabilize the dynamics of public debt, while others are safely below the critical level of 1 (Chile, Colombia, Mexico and Peru) displaying extraordinarily strong fiscal positions. Brazil starts out with relatively high levels of public debt and displays a non-convergent debt dynamics that will require timely adjustments to public finances to preserve its current credit standing.

Source: FocusEconomics.

When assessing overall macroeconomic vulnerability, the region clusters into 3 groups. One group is composed of Chile, Colombia, Peru and Mexico—countries with full access to international markets and multilateral financing and strong macroeconomic fundamentals. Another group is composed of Argentina and Venezuela—countries with limited access to international financial markets and multilateral financing and weak economic fundamentals. Finally, Brazil belongs to the final and intermediate group, with full access to international financial markets and multilateral financing, yet displaying vulnerabilities in some macroeconomic dimensions—especially on the fiscal front. Notably, the growth outlook for the five-year period 2014-2018 according to market consensus forecasts clusters these seven countries into the same three groups (see Figure 5).

The magnitude of macroeconomic challenges will depend on whether the countries be­long to a cluster with strong, mixed or weak macroeconomic fundamentals. For the countries with strong macroeconomic funda­mentals (Chile, Colombia, Mexico and Peru) the key challenge is to consolidate macroeconomic stability in more trying times. For the countries with weak macroeconomic fun­damentals, the need is to urgently restore confidence to stop capital outflows and the drain on international reserves, and to resuscitate their ailing economies. For Brazil, with mixed macroeconomic fun­damentals, the challenge is to react in a timely fashion on the fiscal front to avoid compromising its current credit standing.

From a development perspective, pro-growth reforms will be needed in every country in the region—those with strong and weak macroeconomic fundamentals—to revitalize what otherwise will be a lackluster growth performance in the years to come. More adverse conditions may provide the right incentives for precisely that, for those are the times when politically complex decisions are usually made.

After a decade of high growth and high expectations about the region’s future, the new and less complacent global context implies a return to lackluster growth rates of 3.3 percent over the next five years, from 2014 to 2018. Such a reduction in the cruising speed of the region comes as a result of the change in outlook for growth in advanced economies (mired in what has been called “secular stagnation”); the imminent end to China’s investment-led, credit-propelled growth model and further slowdown in its economy; softening commodity prices; and a gradual increase in the cost of international financing for emerging markets.

What are the macroeconomic challenges that lie ahead for the region? To answer this question we have constructed a series of indicators that are comparable across countries. Every indicator is normalized so that whenever the value is below 1 it denotes a positive outlook and when the value is above 1 it denotes a negative outlook in each macroeconomic dimension.

What emerges is a not a narrative of one Latin America, but of three: one with sound macroeconomic fundamentals (Chile, Colombia, Mexico and Peru), one with weak fundamentals (Argentina and Venezuela), and one with mixed fundamentals (Brazil). Each cluster faces a different outlook and different policy challenges.

Source: Own calculations based on the IMF Financial Soundness Indicators and national statistics for Venezuela.

After a string of banking crises, debt restructurings and financial distress, the health of the financial system in the region has improved significantly. Clearly, the tightening of the regulation and supervision of the region’s banking systems during the last decade appears to have paid off.

In order to assess the banking outlook, we developed a Banking Vulnerability Ratio defined as the ratio of projected nonperforming loans under more adverse economic conditions—higher interest rates, lower growth and depreciating currencies—to maximum nonperforming loans (defined as the level of non-performing loans that would exhaust existing loan-loss provisions and bank capital). Surprisingly, the Banking Vulnerability Ratio is below 1 for each and every country in the region, meaning that if we rule out extreme events, banks in the region are in a strong position to endure a deterioration in economic conditions. From a macroeconomic perspective, this time around the weak link does not appear to be the banking system.

Source: Own calculations based on national statistics, IMF, IADB, CAF and FLAR.

Since the beginning of the cooling-off period in mid-2011, there has been a sharp contrast in the behavior of international reserves between countries with full access and those with limited access to international financial markets. While they have continued to increase in the former (Brazil, Chile, Colombia, Mexico and Peru), they declined significantly in the latter (Argentina and Venezuela).

To assess the international liquidity position we developed the International Liquidity Ratio. The International Liquidity Ratio is defined as the ratio of short-term debt obligations of the public sector—both domestic and external and including the stock of central bank sterilization in­struments—and short-term external debt obligations of the corporate non-financial private sector due in the next 12 months to international reserves, plus the already agreed ex-ante contingent credit lines and potential credit lines that could be negotiated with multilat­eral or regional financial institutions.

We find that the countries in the first cluster—Chile, Colombia, Mexico and Peru—have a strong liquidity position which provides them with an effective cushion to weather episodes of financial turbulence in international capital markets, while Argentina and Venezuela have a very weak international liquidity position. Brazil is in an intermediate, borderline position.

Source: National statistics and private sector estimations for Argentina. Forecasts are obtained from FocusEconomics and Econviews for Argentina.

In order to assess the inflation outlook, we consider a country to have a positive (negative) outlook for inflation if it is expected to remain or fall below (rise above) 4 percent in the next three years. With this definition, we developed an Inflation Vulnerability Ratio, defined as the ratio of projected inflation at the end of 2016 to a 4 percent inflation threshold.

Once again, a heterogeneous picture arises in which some countries have a very negative inflation outlook (Argentina and Venezuela) and face the need to make substantial policy adjustments, while some others have an extraordinarily strong and sustained track record of very low and relatively stable inflation rates (Chile, Colombia, Mexico and Peru). Brazil misses the mark by a relatively small margin.

Source: Own calculations based on national statistics and IMF World Economic Outlook.

To evaluate the strength of the fis­cal position we de­veloped a Fiscal Vulnerability Ratio. The Fiscal Vulnerability Ratio is defined as the ratio of projected debt to GDP over 15 years (assuming identical inflation tax revenues for every country) to a 50 percent debt to GDP thresh­old.

A very diverse picture emerges between countries with very vulnerable fiscal positions (Argentina and Venezuela) facing the need to make substantial policy adjustments to stabilize the dynamics of public debt, while others are safely below the critical level of 1 (Chile, Colombia, Mexico and Peru) displaying extraordinarily strong fiscal positions. Brazil starts out with relatively high levels of public debt and displays a non-convergent debt dynamics that will require timely adjustments to public finances to preserve its current credit standing.

Source: FocusEconomics.

When assessing overall macroeconomic vulnerability, the region clusters into 3 groups. One group is composed of Chile, Colombia, Peru and Mexico—countries with full access to international markets and multilateral financing and strong macroeconomic fundamentals. Another group is composed of Argentina and Venezuela—countries with limited access to international financial markets and multilateral financing and weak economic fundamentals. Finally, Brazil belongs to the final and intermediate group, with full access to international financial markets and multilateral financing, yet displaying vulnerabilities in some macroeconomic dimensions—especially on the fiscal front. Notably, the growth outlook for the five-year period 2014-2018 according to market consensus forecasts clusters these seven countries into the same three groups (see Figure 5).

The magnitude of macroeconomic challenges will depend on whether the countries be­long to a cluster with strong, mixed or weak macroeconomic fundamentals. For the countries with strong macroeconomic funda­mentals (Chile, Colombia, Mexico and Peru) the key challenge is to consolidate macroeconomic stability in more trying times. For the countries with weak macroeconomic fun­damentals, the need is to urgently restore confidence to stop capital outflows and the drain on international reserves, and to resuscitate their ailing economies. For Brazil, with mixed macroeconomic fun­damentals, the challenge is to react in a timely fashion on the fiscal front to avoid compromising its current credit standing.

From a development perspective, pro-growth reforms will be needed in every country in the region—those with strong and weak macroeconomic fundamentals—to revitalize what otherwise will be a lackluster growth performance in the years to come. More adverse conditions may provide the right incentives for precisely that, for those are the times when politically complex decisions are usually made.

Event Information

In an increasingly uncertain global context and less favorable external conditions, Latin America’s growth is experiencing a sharp decline, and the region is expected to grow a meager 2 percent in 2014. Country after country, growth rates have been disappointing and have not only unsurfaced social discontent but pose significant macroeconomic challenges in the years ahead.

On October 2, the Brookings Global-CERES Economic and Social Policy in Latin America Initiative hosted a discussion on the key macroeconomic policy challenges the region´s policymakers now face as well as how to address them. Panelists included: José Juan Ruiz Gόmez, chief economist and manager of the research department at the Inter-American Development Bank; Ernesto Talvi, director of the Brookings Global-CERES Economic and Social Policy in Latin America Initiative; Augusto de la Torre, chief economist for Latin American and the Caribbean at the World Bank; Alejandro Werner, director of the western hemisphere department at the International Monetary Fund. Vice President Kemal Derviş, director of Global Economy and Development at Brookings, moderated the discussion.

Event Information

In an increasingly uncertain global context and less favorable external conditions, Latin America’s growth is experiencing a sharp decline, and the region is expected to grow a meager 2 percent in 2014. Country after country, growth rates have been disappointing and have not only unsurfaced social discontent but pose significant macroeconomic challenges in the years ahead.

On October 2, the Brookings Global-CERES Economic and Social Policy in Latin America Initiative hosted a discussion on the key macroeconomic policy challenges the region´s policymakers now face as well as how to address them. Panelists included: José Juan Ruiz Gόmez, chief economist and manager of the research department at the Inter-American Development Bank; Ernesto Talvi, director of the Brookings Global-CERES Economic and Social Policy in Latin America Initiative; Augusto de la Torre, chief economist for Latin American and the Caribbean at the World Bank; Alejandro Werner, director of the western hemisphere department at the International Monetary Fund. Vice President Kemal Derviş, director of Global Economy and Development at Brookings, moderated the discussion.

Audio

Transcript

Event Materials

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http://www.brookings.edu/research/reports/2014/09/latin-america-macroeconomic-outlook-talvi?rssid=talvie{7C6EE079-6FB1-491D-A1D3-DA9431D36BEC}http://webfeeds.brookings.edu/~/75776626/0/brookingsrss/experts/talvie~Macroeconomic-Vulnerabilities-in-an-Uncertain-World-One-Region-Three-Latin-AmericasMacroeconomic Vulnerabilities in an Uncertain World: One Region, Three Latin Americas

Depending on the vantage point, Latin America could be seen as either one, two or three regions. From a business cycle perspective, it could be thought of as a single region. From the ease of access to international financial markets and multilateral financing perspective, Latin America could be thought of as two different regions, one with full access and the other with limited access. From a macroeconomic vulnerability perspective, the region should be thought of as three distinct regions with three very different sets of policy challenges. In light of these complexities, this report intends to characterize and understand both the similarities and the heterogeneities among countries in the region.

The Business Cycle

During the previous decade, Latin America (LAC-7) displayed a period of uninterrupted growth with the sole exception of the post-Lehman crisis year. Yet, two very distinct growth phases immediately catch the eye. Between 2004 and 2011—excluding the temporary interruption following the Lehman crisis—LAC-7 countries grew at an average of 6.1 percent per year, substantially above the historical average of 3.7 percent since the early 1990s. However, since 2012, growth rates cooled off significantly, and now the region is expected to grow at a meager 2 percent in 2014. This pattern of expansion and deceleration was, to a greater or lesser extent, displayed by every country in the region, with Venezuela, Argentina, and Brazil experiencing the largest growth reversals and Mexico, the smallest. What lies behind Latin America’s cycle of boom and subsequently sharp deceleration? The striking pattern of co-movement in the region’s economic fluctuations points to the relevance of external factors. This report develops an empirical model that focuses on the role of external factors in explaining output fluctuations in Latin America. These factors include growth rates in advanced economies, growth rates in China, prices of the commodities that LAC-7 both produces and exports, and the cost of international financing for emerging economies. Containing very few external factors, this model does surprisingly well in tracking LAC-7’s output performance and accounts for more than 65 percent of output fluctuations in the region. It also can mimic both the boom and cooling-off periods with digital precision.

The New Global Context

Thus, no attempt to assess the region’s macroeconomic outlook can be made without first assessing the outlook for the key external drivers of Latin America’s business cycle. Although global risks are not in short supply, this report rules out the occurrence of extreme events: the possibility that U.S. interest rates might rise more sharply and abruptly than expected; the fragility of the recovery in the eurozone once again triggering concerns about the viability of the euro; property prices collapsing in China and leading to financial distress and a severe decline in growth rates; or geopolitical tensions leading to a sharp increase in oil prices and a world recession. The underlying assumption of this report on the global outlook is given by current market expectations on growth in advanced economies and China, commodity prices and U.S. interest rates.

In spite of the fact that current output is still significantly below what was predicted before the financial crisis, monetary policy is highly stimulative and interest rates are close to zero, the eurozone is not able to replicate its historical average growth rate, and the U.S. is merely able to do so.

First, the U.S. is expected to grow at an average rate of 2.7 percent in 2014-2018, close to its historical average of 3 percent, while eurozone growth is expected to be substantially below its historical average. In spite of the fact that current output is still significantly below what was predicted before the financial crisis, monetary policy is highly stimulative and interest rates are close to zero, the eurozone is not able to replicate its historical average growth rate, and the U.S. is merely able to do so. These trends point to an underlying weakness that has led many experts to start talking about “secular stagnation” as the new normal.

Second, the outlook for China points toward a gradual deceleration in growth rates due to an unsustainable investment-led-credit-propelled model of growth that followed the collapse in export growth after the global crisis.

Third, the outlook for growth in advanced economies and China is consistent with an expected softening in commodity prices that LAC-7 countries both produce and export and a gradual increase in U.S. interest rates leading in turn to a gradual increase in the cost of international financing for emerging markets.

What does this global outlook imply for Latin America? The projections of the empirical model developed for this report are consistent with the market’s consensus forecast of 3.3 percent average growth rate for 2014-2018, close to the region’s historical average since the 1990s, close to estimates of potential output growth of 3.6 percent, and substantially below the boom period of 2004-2011.The latter holds true for every Latin American economy with the notable exception of Mexico.

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Depending on the vantage point, Latin America could be seen as either one, two or three regions. From a business cycle perspective, it could be thought of as a single region. From the ease of access to international financial markets and multilateral financing perspective, Latin America could be thought of as two different regions, one with full access and the other with limited access. From a macroeconomic vulnerability perspective, the region should be thought of as three distinct regions with three very different sets of policy challenges. In light of these complexities, this report intends to characterize and understand both the similarities and the heterogeneities among countries in the region.

The Business Cycle

During the previous decade, Latin America (LAC-7) displayed a period of uninterrupted growth with the sole exception of the post-Lehman crisis year. Yet, two very distinct growth phases immediately catch the eye. Between 2004 and 2011—excluding the temporary interruption following the Lehman crisis—LAC-7 countries grew at an average of 6.1 percent per year, substantially above the historical average of 3.7 percent since the early 1990s. However, since 2012, growth rates cooled off significantly, and now the region is expected to grow at a meager 2 percent in 2014. This pattern of expansion and deceleration was, to a greater or lesser extent, displayed by every country in the region, with Venezuela, Argentina, and Brazil experiencing the largest growth reversals and Mexico, the smallest. What lies behind Latin America’s cycle of boom and subsequently sharp deceleration? The striking pattern of co-movement in the region’s economic fluctuations points to the relevance of external factors. This report develops an empirical model that focuses on the role of external factors in explaining output fluctuations in Latin America. These factors include growth rates in advanced economies, growth rates in China, prices of the commodities that LAC-7 both produces and exports, and the cost of international financing for emerging economies. Containing very few external factors, this model does surprisingly well in tracking LAC-7’s output performance and accounts for more than 65 percent of output fluctuations in the region. It also can mimic both the boom and cooling-off periods with digital precision.

The New Global Context

Thus, no attempt to assess the region’s macroeconomic outlook can be made without first assessing the outlook for the key external drivers of Latin America’s business cycle. Although global risks are not in short supply, this report rules out the occurrence of extreme events: the possibility that U.S. interest rates might rise more sharply and abruptly than expected; the fragility of the recovery in the eurozone once again triggering concerns about the viability of the euro; property prices collapsing in China and leading to financial distress and a severe decline in growth rates; or geopolitical tensions leading to a sharp increase in oil prices and a world recession. The underlying assumption of this report on the global outlook is given by current market expectations on growth in advanced economies and China, commodity prices and U.S. interest rates.

In spite of the fact that current output is still significantly below what was predicted before the financial crisis, monetary policy is highly stimulative and interest rates are close to zero, the eurozone is not able to replicate its historical average growth rate, and the U.S. is merely able to do so.

First, the U.S. is expected to grow at an average rate of 2.7 percent in 2014-2018, close to its historical average of 3 percent, while eurozone growth is expected to be substantially below its historical average. In spite of the fact that current output is still significantly below what was predicted before the financial crisis, monetary policy is highly stimulative and interest rates are close to zero, the eurozone is not able to replicate its historical average growth rate, and the U.S. is merely able to do so. These trends point to an underlying weakness that has led many experts to start talking about “secular stagnation” as the new normal.

Second, the outlook for China points toward a gradual deceleration in growth rates due to an unsustainable investment-led-credit-propelled model of growth that followed the collapse in export growth after the global crisis.

Third, the outlook for growth in advanced economies and China is consistent with an expected softening in commodity prices that LAC-7 countries both produce and export and a gradual increase in U.S. interest rates leading in turn to a gradual increase in the cost of international financing for emerging markets.

What does this global outlook imply for Latin America? The projections of the empirical model developed for this report are consistent with the market’s consensus forecast of 3.3 percent average growth rate for 2014-2018, close to the region’s historical average since the 1990s, close to estimates of potential output growth of 3.6 percent, and substantially below the boom period of 2004-2011.The latter holds true for every Latin American economy with the notable exception of Mexico.

After what has been an eventful year for Latin America, and in light of the upcoming launch of the 2014 annual report “Macroeconomic Vulnerabilities in an Uncertain World: One Region, Three Latin Americas” on October 2nd in Washington D.C. (you can register for the live webcast here), we thought it would be a good time to look back at the key findings of last year’s report “Are the Golden Years for Latin America Over?” and see how events actually unfolded. We also provide a brief preview of the 2014 report.

The 2013 report highlighted two key ideas:

In contrast with the 6.6 percent average growth rates prevailing between September 2003 and September 2008 – the pre-Lehman-crisis “Golden Years” for the region – LAC-7 GDP growth rates in 2012-13 decelerated significantly and reverted back to their mediocre historical average displayed over the last 20 years. The sharp cooling-off that LAC-7 experienced during 2012-13 was the natural and predictable outcome of external conditions that remained generally favorable for the region, but that had ceased to improve continuously as they did in the period 2004-2008 (see Figure 1).

Figure 1. External Conditions Index for LAC-7

It is not the case that the region is doing relatively well in a more hostile external environment, but rather, the region’s growth rates are slowing down significantly in spite of the fact that the external environment remained overall generally favorable. In other words “unless we anticipate external conditions to improve significantly relative to 2012-13 levels, the observed slowdown in growth rates is not an oddity that will go away any time soon, but rather, the “new normal” even if external conditions remain favorable”.

Although the external environment has, generally speaking, remained relatively benign, in the year since the last report Latin America growth rates continued to decelerate even further and the region is estimated to grow at a dismal 2 percent in 2014. Brazil, the region's largest economy, is expected to grow at close to 1 percent; Mexico’s performance has surprised markets on the downside with a growth projection for 2014 of 2.7 percent, while Argentina is technically in a recession.

Although the odds of tail-risk scenarios appear to have been greatly reduced, the external environment for Latin America is expected to become increasingly less favorable for the region, and consensus forecasts point toward continued lackluster growth rates in the foreseeable future.

Looking ahead, this year’s report attempts to answer some key questions. Are there any prospects for growth rates to recover to robust levels? How worried should policymakers be about growing social discontent linked to the lackluster economic performance of recent years? What are the pressing macroeconomic vulnerabilities the region will face in the coming years? Are Latin American banks sufficiently resilient to more adverse economic conditions? And is the diagnosis appropriate for the region as a whole, or for clusters of distinct groups of countries with very different sets of vulnerabilities and policy challenges?

This commentary was written with the invaluable collaboration of Julia Ruiz, research assistant at the Brookings Global-CERES Economic & Social Policy in Latin America Initiative (ESPLA).

Authors

After what has been an eventful year for Latin America, and in light of the upcoming launch of the 2014 annual report “Macroeconomic Vulnerabilities in an Uncertain World: One Region, Three Latin Americas” on October 2nd in Washington D.C. (you can register for the live webcast here), we thought it would be a good time to look back at the key findings of last year’s report “Are the Golden Years for Latin America Over?” and see how events actually unfolded. We also provide a brief preview of the 2014 report.

The 2013 report highlighted two key ideas:

In contrast with the 6.6 percent average growth rates prevailing between September 2003 and September 2008 – the pre-Lehman-crisis “Golden Years” for the region – LAC-7 GDP growth rates in 2012-13 decelerated significantly and reverted back to their mediocre historical average displayed over the last 20 years. The sharp cooling-off that LAC-7 experienced during 2012-13 was the natural and predictable outcome of external conditions that remained generally favorable for the region, but that had ceased to improve continuously as they did in the period 2004-2008 (see Figure 1).

Figure 1. External Conditions Index for LAC-7

It is not the case that the region is doing relatively well in a more hostile external environment, but rather, the region’s growth rates are slowing down significantly in spite of the fact that the external environment remained overall generally favorable. In other words “unless we anticipate external conditions to improve significantly relative to 2012-13 levels, the observed slowdown in growth rates is not an oddity that will go away any time soon, but rather, the “new normal” even if external conditions remain favorable”.

Although the external environment has, generally speaking, remained relatively benign, in the year since the last report Latin America growth rates continued to decelerate even further and the region is estimated to grow at a dismal 2 percent in 2014. Brazil, the region's largest economy, is expected to grow at close to 1 percent; Mexico’s performance has surprised markets on the downside with a growth projection for 2014 of 2.7 percent, while Argentina is technically in a recession.

Although the odds of tail-risk scenarios appear to have been greatly reduced, the external environment for Latin America is expected to become increasingly less favorable for the region, and consensus forecasts point toward continued lackluster growth rates in the foreseeable future.

Looking ahead, this year’s report attempts to answer some key questions. Are there any prospects for growth rates to recover to robust levels? How worried should policymakers be about growing social discontent linked to the lackluster economic performance of recent years? What are the pressing macroeconomic vulnerabilities the region will face in the coming years? Are Latin American banks sufficiently resilient to more adverse economic conditions? And is the diagnosis appropriate for the region as a whole, or for clusters of distinct groups of countries with very different sets of vulnerabilities and policy challenges?

This commentary was written with the invaluable collaboration of Julia Ruiz, research assistant at the Brookings Global-CERES Economic & Social Policy in Latin America Initiative (ESPLA).

Many foreign-policy analysts say that the United States' relationship with Latin America is one of “benign neglect.” US officials dispute this, arguing that American companies are among the region’s largest foreign direct investors, while 11 of the US’s 20 free-trade agreements (FTAs) are with Latin American countries. And insofar as “benign neglect” might be a fair description, it is a positive one, characterized by the absence of geopolitical tension or instability in the region.

But much more could be done—especially on trade policy—to deepen US-Latin American economic relations. Since the breakdown of the Doha Round of global trade talks, the US has been involved in two major international trade negotiations.

Both proposed FTAs—the Trans-Pacific Partnership (TPP), mainly a US-Asia initiative, and the Transatlantic Trade and Investment Partnership (TTIP), a largely US-Europe project—are far-reaching agreements. They aim to restore momentum toward an open global trade regime, including progress on contentious issues like trade in services, intellectual property rights, government procurement, and the harmonization of safety, health, and technical standards. Their participants account for 60% of world GDP. However, they do not reach all places.

Though Chile, Peru, and Mexico have also signed up to the TPP—and other Latin American countries are welcome to join it—the region’s involvement is marginal. If that is to change, the region will need to rediscover the spirit of the 1994 Summit of the Americas, where US President Bill Clinton and his Latin American counterparts set out a grand vision for the hemisphere. Their idea was to create a Free Trade Area of the Americas (FTAA), which would allow goods, capital, and people to move freely anywhere between Alaska and Tierra del Fuego.

One way to revive that spirit of cooperation and common purpose would be to create a new Trans-American Partnership. The TAP would include the US, Canada, Mexico, the Pacific Alliance countries, and other Latin American states that already have FTAs with the US. It would comprise 620 million consumers, and have a combined GDP of more than $22 trillion (larger than the EU’s, and more than double that of China).

The TAP would also embrace almost half of Latin America’s population and include around 50% of its combined GDP, giving the region the central role that it lacks in the TPP or the TTIP. The only major economy that would not initially be in the TAP would be Brazil. But this would surely change as its dynamic private sector, facing down the government’s protectionist instincts, lobbied for membership—a proposition that would become difficult to resist as the TAP’s influence spread.

The TAP could be established and promoted relatively cheaply, by building on and harmonizing current bilateral trade agreements with the US, as many of the Pacific Alliance members have been doing. Moreover, TAP membership would be voluntary, an important advantage over the FTAA.

Most important, the TAP would create a sense of a shared future for the Americas. It could become a formidable force supporting free trade, investment, prosperity, and indeed peace in a multi-polar world.

Such large trade agreements have become particularly important as a means to bridge the two competing economic and ideological models that increasingly divide the world: China and Russia’s authoritarian state capitalism and Western-style democracy and rule of law.

There are positive signs that US policy is moving in the right direction. In his November 2013 speech at the Organization of American States, US Secretary of State John Kerry said that partnership with Latin America “will require courage and a willingness to change. But above all, it will require a higher and deeper level of cooperation between us, all of us together, as equal partners in this hemisphere.”

A new, wide-ranging free-trade agreement, with Latin America at its heart, would be an excellent way to realize these hopes.

Authors

Many foreign-policy analysts say that the United States' relationship with Latin America is one of “benign neglect.” US officials dispute this, arguing that American companies are among the region’s largest foreign direct investors, while 11 of the US’s 20 free-trade agreements (FTAs) are with Latin American countries. And insofar as “benign neglect” might be a fair description, it is a positive one, characterized by the absence of geopolitical tension or instability in the region.

But much more could be done—especially on trade policy—to deepen US-Latin American economic relations. Since the breakdown of the Doha Round of global trade talks, the US has been involved in two major international trade negotiations.

Both proposed FTAs—the Trans-Pacific Partnership (TPP), mainly a US-Asia initiative, and the Transatlantic Trade and Investment Partnership (TTIP), a largely US-Europe project—are far-reaching agreements. They aim to restore momentum toward an open global trade regime, including progress on contentious issues like trade in services, intellectual property rights, government procurement, and the harmonization of safety, health, and technical standards. Their participants account for 60% of world GDP. However, they do not reach all places.

Though Chile, Peru, and Mexico have also signed up to the TPP—and other Latin American countries are welcome to join it—the region’s involvement is marginal. If that is to change, the region will need to rediscover the spirit of the 1994 Summit of the Americas, where US President Bill Clinton and his Latin American counterparts set out a grand vision for the hemisphere. Their idea was to create a Free Trade Area of the Americas (FTAA), which would allow goods, capital, and people to move freely anywhere between Alaska and Tierra del Fuego.

One way to revive that spirit of cooperation and common purpose would be to create a new Trans-American Partnership. The TAP would include the US, Canada, Mexico, the Pacific Alliance countries, and other Latin American states that already have FTAs with the US. It would comprise 620 million consumers, and have a combined GDP of more than $22 trillion (larger than the EU’s, and more than double that of China).

The TAP would also embrace almost half of Latin America’s population and include around 50% of its combined GDP, giving the region the central role that it lacks in the TPP or the TTIP. The only major economy that would not initially be in the TAP would be Brazil. But this would surely change as its dynamic private sector, facing down the government’s protectionist instincts, lobbied for membership—a proposition that would become difficult to resist as the TAP’s influence spread.

The TAP could be established and promoted relatively cheaply, by building on and harmonizing current bilateral trade agreements with the US, as many of the Pacific Alliance members have been doing. Moreover, TAP membership would be voluntary, an important advantage over the FTAA.

Most important, the TAP would create a sense of a shared future for the Americas. It could become a formidable force supporting free trade, investment, prosperity, and indeed peace in a multi-polar world.

Such large trade agreements have become particularly important as a means to bridge the two competing economic and ideological models that increasingly divide the world: China and Russia’s authoritarian state capitalism and Western-style democracy and rule of law.

There are positive signs that US policy is moving in the right direction. In his November 2013 speech at the Organization of American States, US Secretary of State John Kerry said that partnership with Latin America “will require courage and a willingness to change. But above all, it will require a higher and deeper level of cooperation between us, all of us together, as equal partners in this hemisphere.”

A new, wide-ranging free-trade agreement, with Latin America at its heart, would be an excellent way to realize these hopes.

Authors

]]>
http://www.brookings.edu/research/opinions/2014/06/06-risks-china-latin-america-talvi?rssid=talvie{4753B433-BFA3-435B-8D16-49E4755502E8}http://webfeeds.brookings.edu/~/66358419/0/brookingsrss/experts/talvie~Enter-the-Dragon-Risks-from-China-to-Latin-AmericaEnter the Dragon: Risks from China to Latin America

Editor’s Note: On May 31–June 3, 2014, Ernesto Talvi participated in the Latin America Shadow Financial Regulatory Committee (CLAAF), held in Washington D.C. The committee is composed of a group of prestigious independent Latin American economists, former policymakers, and academics with strong expertise in the field of macroeconomics, banking and finance and whose goal is to identify and analyze challenges and risks for the region. The following document—Policy Statement Number 31—was released at a press conference immediately following the meetings. It discusses the implications for the region following a major slowdown in China’s growth rates and recommends a series of preventive policy actions for Latin American countries and the international community.

A continuing objective of the Committee is to monitor and assess risks to Latin America stemming from changes in the global economic scenario. In its previous statement, the Committee discussed the implications for the region of a tapering of bond purchases by the US Federal Reserve. In this statement, the Committee discusses the implications of a major slowdown in China’s economic growth, a factor that may worsen the external environment for the region.

I. China’s Changing Growth Prospects

Since the outbreak of the 2007/2008 global financial crisis, China’s economic growth has evolved from primarily export-led to increasingly investment-driven. As a result, China’s investment has risen to about 50 percent of GDP.

Notwithstanding its high investment rate, there are a number of compelling reasons why China may be facing a significant slowdown in growth. Firstly, the quality of investment has been uneven, as it led to overcapacity in the real estate sector and a surge in spending by local governments in ambitious, but low-productivity infrastructure projects. In turn, the declining quality of projects, coupled with significant indebtedness in the corporate sector and in local governments, is likely to lead to lower investment ratios and reduced growth prospects.

Secondly, the rapid increase in China’s investment has been associated with an equally rapid increase in domestic credit. Total social financing increased from just above 120 percent of GDP in 2008 to over 200 percent of GDP in 2014.[1] While a significant portion of the expansion of credit has taken place through the regulated banking system, increasingly credit has been channeled through trusts and other non-regulated vehicles normally referred to as “shadow banking”. Assets in the shadow banking system are currently estimated at 30 percent of the traditional banking system’s assets. The combination of a rapid credit boom and low-productivity investment has raised the fragility of the financial sector in China.

On the liability side, the presence of ceilings on interest rates at banks has stimulated the expansion of unregulated financial institutions. In an attempt to foster competition in the financial sector and reduce the growth of shadow banking, Chinese authorities are considering removing such ceilings on deposit interest rates; lending rates were liberalized in 2013. However, an increase in financing costs may result in a further deterioration of the financial sector’s balance sheet.

The Committee believes that current financial fragilities could result in a rapid contraction in new lending, contributing to the slowdown in China’s GDP growth. The contraction in credit may be occurring at a time when Chinese authorities are tightening regulations in an attempt to contain the expansion of shadow banking. Furthermore, if the resolution of the financial fragilities extends over time, the above lower-growth scenario may also become persistent.

II. Channels of Transmission to Latin America

A scenario in which China’s economic growth slows down significantly has important implications for Latin America. The Committee has identified the following main channels of transmission to the region, although the relative importance of these channels varies significantly across countries:

a.) Commodity Prices

Historically South America has been a net exporter of primary commodities. In 2012, for instance, the sum of agricultural, fuel and mineral exports represented 97, 84, 78, 64, and 62 percent of total exports for Venezuela, Chile, Colombia, Argentina, and Brazil, respectively. With the exception of Brazil, the exports of the other countries are heavily concentrated in one or two commodities.

China’s imports of primary commodities surged during the last decade exerting significant upward pressures on international commodity prices. For most countries this implied improved terms of trade. Since the 2000 lows to their 2012 peak, terms of trade increased, for example, by 82 percent in Chile, 63 percent in Peru and 51percent in Colombia.

The favorable international environment that commodity exporters enjoyed during this period was an important contributor to their rapid growth. Since mid-2011 most commodity prices have softened and the Committee believes that a marked slowdown in China may exacerbate this trend.

The extent of the adverse shock derived from China’s slowdown will differ among countries depending on a number of factors such as the degree of openness and dependence on external trade, the composition of exports, and sensitivity of commodity prices to changes in Chinese growth.

Whatever the specific result is in each case, the slowdown and rebalancing in China will entail fiscal challenges for Latin America, in some cases substantive. First, governments that are reliant on revenues from commodities may need to adjust in order to maintain fiscal sustainability. Second, authorities will have to contend with pressures to subsidize the affected commodity-producing sectors. Third, governments will need to reassess their contingent liabilities associated with the outstanding debt of commodity producers.

The high volume of capital inflows to the region and foreign direct investment until 2013 was a consequence of both the commodity boom and high global liquidity and, from 2008 onwards, low growth prospects in industrialized countries. A further weakening of terms of trade may, by itself, lead to a reduction or reversal of capital inflows and increased borrowing costs.

b.) Reassessment of Risk in Emerging Markets

For emerging markets outside of Eastern Europe, the decade 2004-2013 was relatively crisis free. On the whole, notwithstanding the sharp interruption associated with the subprime crisis and its global spillovers during 2008-2009, emerging markets as an asset class were revalued for their comparatively strong fundamentals, notably vìs-a-vìs the debt-laden advanced economies. This period of comparative prosperity, rising sovereign credit ratings and substantial capital inflows was a contrast to the turbulence of the preceding decade, which saw the Mexican peso crisis of 1994-1995 and its spillovers, the widespread Asian crisis of 1997-1998, the Russian and Long Term Capital Market crises of the fall of 1998, and the Argentine default and contagion to Uruguay during 2001-2003.

External factors, notably low and declining interest rates in the United States and other advanced economies, high commodity prices, and robust growth in China had importantly favored emerging markets at a time during which credit ratings in the advanced economies (most markedly periphery Europe) were sliding, in some cases below investment grade.

By early 2013, following one of the most prolonged capital inflow bonanzas in history, signs of vulnerability had reemerged in a number of countries. The “Fragile Five” comprised of Brazil, India, Indonesia, South Africa and Turkey (among others) were manifesting an assortment of weakening fundamentals that included in varying degrees: the reappearance of current account deficits, domestic credit booms, currency overvaluation, and bubbly real estate prices. Growth had begun to slow and in some cases inflation had resurfaced as a concern. Complex domestic problems in Argentina and Venezuela made matters worse. In that environment, in May 2013 came the announcement of QE tapering that marked the first significant post-bonanza reassessment of risk for the emerging market class. The trend toward convergence in credit ratings between advanced and emerging markets has, at least for the time being, came to a halt.

Despite some abatement of concerns about an imminent tightening in US monetary policy, other shifts in external factors have emerged to pose risks for emerging markets in general, and commodity producers in particular. The Committee believes that a slowdown in China and signs of stabilization in periphery Europe (which was buffeted by massive capital outflows and loss of capital market access through 2013) has begun to adversely tilt financial markets assessment of the risks in emerging markets.

In the past, as in the period following the Asian crisis, this reduced appetite for emerging market assets was associated with a marked slowing in capital inflows, and in some cases a sudden stop, with its deleterious consequences for growth. The Committee believes that these conditions place emerging markets in a vulnerable position which, as past episodes teach, could spawn contagion. Hence, a crisis in one major emerging market could quickly spread to the whole asset class. Moreover, as the 1998 crisis shows, contagion could be exacerbated if developed capital market participants suffer a liquidity crunch following an EM crisis. Recent evidence shows that foreign investors have in recent years increased their exposure in China in a significant manner, a fact that could raise the risks of “fast and furious” contagion.

c.) Foreign Direct Investment

In recent years, Chinese foreign direct investment has grown substantially and has provided an additional boost to growth in the region. Investment has been directed mainly at Argentina, Brazil, and Peru and, to a lesser extent, to Ecuador and Mexico. Investments have been concentrated mainly on agriculture, energy and mining and, to a lesser extent, on telecommunications, automotive, and railroads. More recently, Chinese investments have also started in the banking sector through the purchase by ICBC and CCBC of medium-sized banks in Argentina and Brazil.

In an environment of uncertain Chinese growth prospects it is less clear if foreign direct investment from China to Latin America will remain strong. A possible scenario is that a slowdown of domestic investment in China may lead to an increase in its current account. In that case, China’s foreign direct investment to the region in strategic sectors may increase. This is especially so if further investment in agriculture, mining, and energy may become relatively more attractive in a context of lower commodity prices.

Alternatively, the decline in investment could be more generalized affecting both domestic and foreign investment. In this scenario, the international transmission of the slowdown of China is likely to add a recessionary pressure on the global economy.

d.) Emerging Financial Links via Chinese Banks

As mentioned above, Chinese banks have recently begun entering financial markets in Latin America. So far, the size of the investments has been relatively small but it is expected that their presence in the region will expand in the future. The presence of Chinese banks is likely to be a positive development for the region in terms of their role in providing trade finance, thus supporting the growth of trade flows between Latin America and China.

In addition, the presence of Chinese banks in the region may reflect a strategy on the part of China to increase financing to the growing role of Chinese companies while hedging exchange and political risk.

However, Latin American regulators should be increasingly aware of the potential spillover of financial fragilities in China. In the recent crisis, some international banks have used their branches and subsidiaries in the region to channel funds to their headquarters in order to mitigate the effects of the credit crunch suffered in the advanced economies. A similar situation may arise in this context as well, although the current presence of Chinese banks is still very limited in size. The lack of convertibility of the renmimbi limits significantly the importance of this channel.

Financial links between China and Latin America have also increased recently at the official level. In September 2013, it has been agreed to set up a USD 100 billion BRICS Liquidity Fund by 2015. China’s contribution to the fund is expected to be USD 41 billion, compared to Brazil’s, India’s, and Russia’s contribution of USD 18 billion, and South Africa’s contribution of USD 5 billion. Also, central banks of Argentina and Brazil have set up swap agreements in domestic currency with the People’s Bank of China. The main aim of these agreements is to complement the role of other multilaterals in improving access to external funding in systemic episodes of turbulence in international capital markets, and to reduce the potential of disruptions in trade finance. Although still largely untested, these initiatives may eventually play a beneficial role in reducing the vulnerability of the region to external shocks.

III. Policy Recommendations

In order to help countries adopt precautionary policies and international financial institutions (IFIs) to be prepared to provide adequate support in case of need, the Committee recommends following a two-step approach to quantify spillover risks identified above. Over the short term, countries should perform and release, in a credible and transparent way, a series of stress tests of financial, fiscal, and external vulnerabilities stemming from decline in commodity prices and financial disruptions, caused by different combinations of a potential China’s significant slowdown and a global liquidity tightening.

Over the medium term, the Committee recommends these stress tests to be performed in a coordinated way, with a common framework, and with the support of global and regional IFI’s, in particular the International Monetary Fund (IMF). Results should be released following strict transparency standards.

The Committee believes that, in light of the risks discussed, the IMF should strengthen its efforts to be able to act as an international lender of last resort. The time to meet the call for recapitalizing the IMF is now, when the risks assessed in this and previous CLAAF statements have not yet fully materialized. This recapitalization is essential to make credible the automatic recourse to emergency financing facilities by eligible members, without compromising the IMF’s capacity to fully utilize its other facilities.

As long as the IMF does not become a full international lender of last resort, the Committee believes that it is critical for countries to build or maintain adequate external liquidity cushions, commensurate with these risks. A regional institution such as the Fondo Latinoamericano de Reservas (FLAR)could play an important complementary role in strengthening the region’s liquidity.

In order to have enough policy space to respond to a deterioration of external conditions and to facilitate the smooth absorption of potential shocks countries need to have strong fiscal and monetary policies, and to allow for exchange rate flexibility. It is reassuring that some of the countries in the region with higher exposure to a significant China slowdown are precisely those that are better prepared to handle it (such as Chile and Peru).

[1] Total social financing (TSF) is defined by the People’s Bank of China as an economic barometer that sums up total funding by Chinese non-state entities, including individuals and non-financial corporates, such as corporate bonds, bank and trust loans, and bank acceptance bills.

Editor’s Note: On May 31–June 3, 2014, Ernesto Talvi participated in the Latin America Shadow Financial Regulatory Committee (CLAAF), held in Washington D.C. The committee is composed of a group of prestigious independent Latin American economists, former policymakers, and academics with strong expertise in the field of macroeconomics, banking and finance and whose goal is to identify and analyze challenges and risks for the region. The following document—Policy Statement Number 31—was released at a press conference immediately following the meetings. It discusses the implications for the region following a major slowdown in China’s growth rates and recommends a series of preventive policy actions for Latin American countries and the international community.

A continuing objective of the Committee is to monitor and assess risks to Latin America stemming from changes in the global economic scenario. In its previous statement, the Committee discussed the implications for the region of a tapering of bond purchases by the US Federal Reserve. In this statement, the Committee discusses the implications of a major slowdown in China’s economic growth, a factor that may worsen the external environment for the region.

I. China’s Changing Growth Prospects

Since the outbreak of the 2007/2008 global financial crisis, China’s economic growth has evolved from primarily export-led to increasingly investment-driven. As a result, China’s investment has risen to about 50 percent of GDP.

Notwithstanding its high investment rate, there are a number of compelling reasons why China may be facing a significant slowdown in growth. Firstly, the quality of investment has been uneven, as it led to overcapacity in the real estate sector and a surge in spending by local governments in ambitious, but low-productivity infrastructure projects. In turn, the declining quality of projects, coupled with significant indebtedness in the corporate sector and in local governments, is likely to lead to lower investment ratios and reduced growth prospects.

Secondly, the rapid increase in China’s investment has been associated with an equally rapid increase in domestic credit. Total social financing increased from just above 120 percent of GDP in 2008 to over 200 percent of GDP in 2014.[1] While a significant portion of the expansion of credit has taken place through the regulated banking system, increasingly credit has been channeled through trusts and other non-regulated vehicles normally referred to as “shadow banking”. Assets in the shadow banking system are currently estimated at 30 percent of the traditional banking system’s assets. The combination of a rapid credit boom and low-productivity investment has raised the fragility of the financial sector in China.

On the liability side, the presence of ceilings on interest rates at banks has stimulated the expansion of unregulated financial institutions. In an attempt to foster competition in the financial sector and reduce the growth of shadow banking, Chinese authorities are considering removing such ceilings on deposit interest rates; lending rates were liberalized in 2013. However, an increase in financing costs may result in a further deterioration of the financial sector’s balance sheet.

The Committee believes that current financial fragilities could result in a rapid contraction in new lending, contributing to the slowdown in China’s GDP growth. The contraction in credit may be occurring at a time when Chinese authorities are tightening regulations in an attempt to contain the expansion of shadow banking. Furthermore, if the resolution of the financial fragilities extends over time, the above lower-growth scenario may also become persistent.

II. Channels of Transmission to Latin America

A scenario in which China’s economic growth slows down significantly has important implications for Latin America. The Committee has identified the following main channels of transmission to the region, although the relative importance of these channels varies significantly across countries:

a.) Commodity Prices

Historically South America has been a net exporter of primary commodities. In 2012, for instance, the sum of agricultural, fuel and mineral exports represented 97, 84, 78, 64, and 62 percent of total exports for Venezuela, Chile, Colombia, Argentina, and Brazil, respectively. With the exception of Brazil, the exports of the other countries are heavily concentrated in one or two commodities.

China’s imports of primary commodities surged during the last decade exerting significant upward pressures on international commodity prices. For most countries this implied improved terms of trade. Since the 2000 lows to their 2012 peak, terms of trade increased, for example, by 82 percent in Chile, 63 percent in Peru and 51percent in Colombia.

The favorable international environment that commodity exporters enjoyed during this period was an important contributor to their rapid growth. Since mid-2011 most commodity prices have softened and the Committee believes that a marked slowdown in China may exacerbate this trend.

The extent of the adverse shock derived from China’s slowdown will differ among countries depending on a number of factors such as the degree of openness and dependence on external trade, the composition of exports, and sensitivity of commodity prices to changes in Chinese growth.

Whatever the specific result is in each case, the slowdown and rebalancing in China will entail fiscal challenges for Latin America, in some cases substantive. First, governments that are reliant on revenues from commodities may need to adjust in order to maintain fiscal sustainability. Second, authorities will have to contend with pressures to subsidize the affected commodity-producing sectors. Third, governments will need to reassess their contingent liabilities associated with the outstanding debt of commodity producers.

The high volume of capital inflows to the region and foreign direct investment until 2013 was a consequence of both the commodity boom and high global liquidity and, from 2008 onwards, low growth prospects in industrialized countries. A further weakening of terms of trade may, by itself, lead to a reduction or reversal of capital inflows and increased borrowing costs.

b.) Reassessment of Risk in Emerging Markets

For emerging markets outside of Eastern Europe, the decade 2004-2013 was relatively crisis free. On the whole, notwithstanding the sharp interruption associated with the subprime crisis and its global spillovers during 2008-2009, emerging markets as an asset class were revalued for their comparatively strong fundamentals, notably vìs-a-vìs the debt-laden advanced economies. This period of comparative prosperity, rising sovereign credit ratings and substantial capital inflows was a contrast to the turbulence of the preceding decade, which saw the Mexican peso crisis of 1994-1995 and its spillovers, the widespread Asian crisis of 1997-1998, the Russian and Long Term Capital Market crises of the fall of 1998, and the Argentine default and contagion to Uruguay during 2001-2003.

External factors, notably low and declining interest rates in the United States and other advanced economies, high commodity prices, and robust growth in China had importantly favored emerging markets at a time during which credit ratings in the advanced economies (most markedly periphery Europe) were sliding, in some cases below investment grade.

By early 2013, following one of the most prolonged capital inflow bonanzas in history, signs of vulnerability had reemerged in a number of countries. The “Fragile Five” comprised of Brazil, India, Indonesia, South Africa and Turkey (among others) were manifesting an assortment of weakening fundamentals that included in varying degrees: the reappearance of current account deficits, domestic credit booms, currency overvaluation, and bubbly real estate prices. Growth had begun to slow and in some cases inflation had resurfaced as a concern. Complex domestic problems in Argentina and Venezuela made matters worse. In that environment, in May 2013 came the announcement of QE tapering that marked the first significant post-bonanza reassessment of risk for the emerging market class. The trend toward convergence in credit ratings between advanced and emerging markets has, at least for the time being, came to a halt.

Despite some abatement of concerns about an imminent tightening in US monetary policy, other shifts in external factors have emerged to pose risks for emerging markets in general, and commodity producers in particular. The Committee believes that a slowdown in China and signs of stabilization in periphery Europe (which was buffeted by massive capital outflows and loss of capital market access through 2013) has begun to adversely tilt financial markets assessment of the risks in emerging markets.

In the past, as in the period following the Asian crisis, this reduced appetite for emerging market assets was associated with a marked slowing in capital inflows, and in some cases a sudden stop, with its deleterious consequences for growth. The Committee believes that these conditions place emerging markets in a vulnerable position which, as past episodes teach, could spawn contagion. Hence, a crisis in one major emerging market could quickly spread to the whole asset class. Moreover, as the 1998 crisis shows, contagion could be exacerbated if developed capital market participants suffer a liquidity crunch following an EM crisis. Recent evidence shows that foreign investors have in recent years increased their exposure in China in a significant manner, a fact that could raise the risks of “fast and furious” contagion.

c.) Foreign Direct Investment

In recent years, Chinese foreign direct investment has grown substantially and has provided an additional boost to growth in the region. Investment has been directed mainly at Argentina, Brazil, and Peru and, to a lesser extent, to Ecuador and Mexico. Investments have been concentrated mainly on agriculture, energy and mining and, to a lesser extent, on telecommunications, automotive, and railroads. More recently, Chinese investments have also started in the banking sector through the purchase by ICBC and CCBC of medium-sized banks in Argentina and Brazil.

In an environment of uncertain Chinese growth prospects it is less clear if foreign direct investment from China to Latin America will remain strong. A possible scenario is that a slowdown of domestic investment in China may lead to an increase in its current account. In that case, China’s foreign direct investment to the region in strategic sectors may increase. This is especially so if further investment in agriculture, mining, and energy may become relatively more attractive in a context of lower commodity prices.

Alternatively, the decline in investment could be more generalized affecting both domestic and foreign investment. In this scenario, the international transmission of the slowdown of China is likely to add a recessionary pressure on the global economy.

d.) Emerging Financial Links via Chinese Banks

As mentioned above, Chinese banks have recently begun entering financial markets in Latin America. So far, the size of the investments has been relatively small but it is expected that their presence in the region will expand in the future. The presence of Chinese banks is likely to be a positive development for the region in terms of their role in providing trade finance, thus supporting the growth of trade flows between Latin America and China.

In addition, the presence of Chinese banks in the region may reflect a strategy on the part of China to increase financing to the growing role of Chinese companies while hedging exchange and political risk.

However, Latin American regulators should be increasingly aware of the potential spillover of financial fragilities in China. In the recent crisis, some international banks have used their branches and subsidiaries in the region to channel funds to their headquarters in order to mitigate the effects of the credit crunch suffered in the advanced economies. A similar situation may arise in this context as well, although the current presence of Chinese banks is still very limited in size. The lack of convertibility of the renmimbi limits significantly the importance of this channel.

Financial links between China and Latin America have also increased recently at the official level. In September 2013, it has been agreed to set up a USD 100 billion BRICS Liquidity Fund by 2015. China’s contribution to the fund is expected to be USD 41 billion, compared to Brazil’s, India’s, and Russia’s contribution of USD 18 billion, and South Africa’s contribution of USD 5 billion. Also, central banks of Argentina and Brazil have set up swap agreements in domestic currency with the People’s Bank of China. The main aim of these agreements is to complement the role of other multilaterals in improving access to external funding in systemic episodes of turbulence in international capital markets, and to reduce the potential of disruptions in trade finance. Although still largely untested, these initiatives may eventually play a beneficial role in reducing the vulnerability of the region to external shocks.

III. Policy Recommendations

In order to help countries adopt precautionary policies and international financial institutions (IFIs) to be prepared to provide adequate support in case of need, the Committee recommends following a two-step approach to quantify spillover risks identified above. Over the short term, countries should perform and release, in a credible and transparent way, a series of stress tests of financial, fiscal, and external vulnerabilities stemming from decline in commodity prices and financial disruptions, caused by different combinations of a potential China’s significant slowdown and a global liquidity tightening.

Over the medium term, the Committee recommends these stress tests to be performed in a coordinated way, with a common framework, and with the support of global and regional IFI’s, in particular the International Monetary Fund (IMF). Results should be released following strict transparency standards.

The Committee believes that, in light of the risks discussed, the IMF should strengthen its efforts to be able to act as an international lender of last resort. The time to meet the call for recapitalizing the IMF is now, when the risks assessed in this and previous CLAAF statements have not yet fully materialized. This recapitalization is essential to make credible the automatic recourse to emergency financing facilities by eligible members, without compromising the IMF’s capacity to fully utilize its other facilities.

As long as the IMF does not become a full international lender of last resort, the Committee believes that it is critical for countries to build or maintain adequate external liquidity cushions, commensurate with these risks. A regional institution such as the Fondo Latinoamericano de Reservas (FLAR)could play an important complementary role in strengthening the region’s liquidity.

In order to have enough policy space to respond to a deterioration of external conditions and to facilitate the smooth absorption of potential shocks countries need to have strong fiscal and monetary policies, and to allow for exchange rate flexibility. It is reassuring that some of the countries in the region with higher exposure to a significant China slowdown are precisely those that are better prepared to handle it (such as Chile and Peru).

[1] Total social financing (TSF) is defined by the People’s Bank of China as an economic barometer that sums up total funding by Chinese non-state entities, including individuals and non-financial corporates, such as corporate bonds, bank and trust loans, and bank acceptance bills.